The Case of Tax Audit Insurance

Maurer School of Law: Indiana University Digital Repository @ Maurer Law Articles by Maurer Faculty Faculty Scholarship 1985 Taxing Personal Insurance: The Case of Tax Audit Insurance William D. Popkin Indiana University Maurer School of Law, [email protected] Follow this and additional works at: https://www.repository.law.indiana.edu/facpub Part of the Insurance Law Commons, Taxation-Federal Commons, and the Tax Law Commons Recommended Citation Popkin, William D., "Taxing Personal Insurance: The Case of Tax Audit Insurance" (1985). Articles by Maurer Faculty. 940. https://www.repository.law.indiana.edu/facpub/940 This Article is brought to you for free and open access by the Faculty Scholarship at Digital Repository @ Maurer Law. It has been accepted for inclusion in Articles by Maurer Faculty by an authorized administrator of Digital Repository @ Maurer Law. For more information, please contact [email protected]. TAXING PERSONAL INSURANCE: THE CASE OF TAX AUDIT INSURANCE William D. Popkin* A recent brochure explaining tax audit insurance' to tax practi- tioners warns that "[e]ven the most meticulously prepared returns are subject to questions about the adequacy or propriety of the documentation and substantiation which the client has accumu- lated and maintained" and that there is "added uncertainty as to how courts will decide complicated provisions."2 Thus warned, taxpayers are expected to find tax audit insurance, which reimburses policyholders for tax deficiences and, in some cases, professional fees, attractive. From the insurance company's viewpoint, tax audit insurance is economically feasible because the company can aggre- gate the statistical probabilities that particular taxpayers will be audited and spread the costs over a large number of insured taxpayers.' Before acquiring this new type of insurance, taxpayers must pay careful attention to how the proceeds and premiums will be taxed. The taxation of any type of personal insurance is difficult to determine, 4 and tax audit insurance raises special problems.5 Addition- * Professor of Law, Indiana University School of Law (Bloomington). Currently, tax audit insurance is only offered to individuals. See infra note 2. Conse- quently, this article is limited to treatment of that insurance as it applies to individuals. 2 Victor 0. Schinnerer & Co., The CPA/Tax Attorney Guide to Taxright Tax Audit Insur- ance 2 (1983) (Tax Notes Doc. No. 83-4555) [hereinafter cited as Audit Insurance Guide]. I Most tax returns are selected for audit from returns identified by statistical formula for their revenue potential. See Comptroller Gen. of the U.S., Report to the Joint Committee on Internal Revenue Taxation, How the Internal Revenue Service Selects Individual Income Tax Returns for Audit 12-27 (1976). But because of the uncertainties contained in the selec- tion process, chance remains a major factor. Different categories of risk are, of course, com- patible with insurance, and translate into varying premiums depending upon the category of audit risk. For example, Exhibit III of the Audit Insurance Guide, supra note 2, specifies different premiums for twelve categories of taxpayers filing Schedule E and four categories of taxpayers who do not file Schedule E but who itemize deductions. See id. at 21. ' See Popkin, Defining Taxable Consumption: A Comment on Personal Insurance Pre- miums, 54 Ind. L.J. 389 (1979). 5 A recent New York State Bar Report argued that the insurance proceeds covering tax deficiencies and professional fees would be taxable, but that the amount spent on professional fees would be deductible. See Comm. on Unreported Income and Compliance, N.Y. State Bar Ass'n Tax Section, A Report on Tax Audit Insurance, reprinted in 22 Tax Notes 53, 55 (1984). According to the Report, the policy premium, with two exceptions, would not 380 Virginia Tax Review [Vol. 4:379 ally, widespread use of tax audit insurance has special policy implications. Insurance reduces the taxpayer's financial burden of an additional assessment after audit and, therefore, might encourage him to be more aggressive in asserting questionable positions in his tax return. The insurance contract, however, has been structured to reduce the taxpayer's incentive to play the tax lottery.' Professional fees are covered only if the insurance company decides to contest an issue.7 Tax deficiencies are covered up to $100,000 per return, but coverage is not provided for penalties and interest, amounts arising from acts which could result in penalties, amounts arising from tax avoidance transactions or transactions without economic substance, amounts arising from omissions of gross income (unless the omission was in good faith), and amounts arising out of mathe- matical and clerical errors.' A taxpayer is eligible for insurance only if his return is prepared by a certified public accountant or an attorney engaged in federal tax practice who is not suspended from practice before the Internal Revenue Service (Service).9 Moreover, the insurance company suggests that the Government may even benefit from tax audit insurance. Funds would be readily available to pay the tax deficiencies, 10 and tax advisors might be less aggressive since questionable positions could affect insurability and the amount of premiums charged." Additionally, a require- ment that the purchase of a tax audit insurance policy be revealed on the return may reduce, rather than increase, the incentive to play the tax lottery.'" be deductible. The premiums allocable to professional fees would be deductible since the fees would be deductible, and the premiums allocable to tax deficiencies would be deductible from any taxable proceeds which the insured collected. See id. The author of this article agrees with some, but not all, of these conclusions. The author agrees that insurance proceeds are taxable but argues that the premiums should never be deductible, not even to reduce taxable proceeds and not even if the expenditure covered by the insurance is itself deductible. See infra notes 102-12 and accompanying text. ' See Audit Insurance Guide, supra note 2, at 6 (policy terms have been discussed with Internal Revenue Service officials). I However, the insured is immediately entitled to $1,000 to reduce the initial impact of a tax audit. See id. at 2. See id. at 3, 23. See id. at 4. 10 See id. at 6. " See Novel Plan Will Insure Against Loss Due to Tax Audits, 19 Tax Notes 759 (1983). 12 See A Report on Tax Audit Insurance, supra note 5, at 55. 1985] Tax Audit Insurance Nonetheless, the advantages to the Government of tax audit insurance are speculative, while the dangers of encouraging taxpayers to play the tax lottery are obvious.1 3 Many of the risks covered by the insurance policy are items on which an aggressive taxpayer might gamble, such as omitting noncash fringe benefits, distinguishing debt from equity, deducting hobby losses, calculating the basis of inherited property, distinguishing ordinary from capital asset property, deducting educational travel expenses, and valuing charitable contributions. 4 The potential effect of tax audit insurance on taxpayer compliance highlights the importance of deter- mining how tax audit insurance should be taxed. Section I of this article will explain the various ways the tax law might treat personal insurance, i.e., insurance protecting against risks arising from personal, rather than income-producing activi- ties.15 This article considers five theories for taxing personal insurance and then examines current law to determine whether any of these theories have been adopted in the Internal Revenue Code (Code). It deals first with insurance replacing lost income, such as life and disability insurance, then considers insurance replacing personal losses, such as medical insurance, and finally, it discusses casualty insurance. Section II then applies this analysis to tax audit insurance. I. TAXING PERSONAL INSURANCE A. Introduction The taxation of personal insurance premiums and proceeds does not fit easily into the conventional patterns of thought defining taxable income. The premiums paid may eventually result in the production of income as the result of an occurrence covered by the policy, but the injured taxpayers do not really want the income to be produced, and would prefer that the loss not occur. The premiums, therefore, are usually characterized as personal, rather than business, expenses."6 It is also true, however, that insurance premi- '3 The risk covered by tax audit insurance is one of economic hardship only, as opposed to the risk of bodily injury, which carries its own disincentives. " See Audit Insurance Guide, supra note 2, at 14-19. " Analysis of personal insurance is instructive because of its relationship to insurance covering federal income taxes, which is a nondeductible expense. "6 See infra note 18. 382 Virginia Tax Review [Vol. 4:379 ums are not typical personal consumption. Taxable personal consumption usually provides the taxpayer with an immediate benefit, such as food, travel, or clothing, rather than an opportunity to re- ceive a large return on an investment. This distinction lends plau- sibility to analyzing the premiums as an investment to produce proceeds, despite the fact that it is an investment the taxpayer does not want to realize. The tension between defining income from personal insurance proceeds and conventional views of defining taxable income helps to explain the number of theories that can justify how personal insurance should be taxed. This article distinguishes between two types of personal insurance. The first type replaces lost income.17 Typical examples are life and disability insurance, which are personal insurance when they cover risks arising from personal activity.' The proceeds of such insurance might be tax-exempt, perhaps out of sympathy for the insured and his family, but the taxpayer unquestionably has income as a result of the insurance coverage. The second type of 17 This income, had it been earned, would have been taxable when received.

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